Sovereign Debt Restructuring and the CDS Market: Competing Objectives and the Case of International Standardization/Harmonisation

The CDS market has been falsely castigated as the culprit behind the Eurozone's sovereign debt woes. As the subprime crisis has proved, CDS trading even when it is not used to hedge an underlying risk, is a very useful mechanism for communicating to the market strong contrarian beliefs. So like short sales they provide a good check of market exuberance and an efficient mechanism for correction of pricing inefficiencies. However, information bearing speculation has its limits. In the case of sovereign debt restructurings the terms for the restructuring are normally determined following negotiations between the borrower and the creditors, diminishing the information value of CDS trading.Sovereign debt restructurings are a good mechanism for returning the debtor country to the path of fiscal viability and economic development. However, uncertainty about the terms of CDS payoffs and continuous CDS trading may generate confusion and fears that postpone or block restructuring efforts. Given the competing objectives involved in the restructuring process is there a valid case for the IMF and ISDA have to devise a model statute/contract that covers a list of CDS 'events of default' which correspond to forms of sovereign debt restructuring in order to create clarity and diminish market uncertainty regarding payoffs. This may be done through a revised IMF SDRM that should now also consider the impact of CDS trading on sovereign debt restructurings. At the same time all naked CDS trading should cease upon initiation of restructuring negotiations.